Undervalued Dividend Growth Stock of the Week: Baxter International (BAX)

February 22, 2015
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Scanning David Fish’s Dividend Champions, Contenders, and Challengers list for high-quality stocks is a pretty fruitful exercise.

After all, that document contains more than 600 US-listed stocks that have increased their dividends for at least the last five consecutive years, with many of them sporting decades of dividend raises.

And since dividends are paid in cash from cash, one can reasonably assume that most of the companies that can grow dividends for decades on end are also growing profits over that same stretch.

While high-quality dividend growth stocks tend to be wonderful investments over long periods of time, it’s also important to pay fair value or less for a stock.

Fair value?

Price (what you pay for something) and value (what something is worth) are almost never correlated at a 1:1 ratio due to the fact that the stock market oscillates every single day, even while major companies’ intrinsic values don’t.

For instance, The Coca-Cola Co. (KO) may fluctuate by 2% here or 3% there, but does KO’s true value – a $184 billion company – really change by $4 billion or $5 billion from one day to the next without any pertinent changes to its fundamentals? Probably not.

So it’s important to separate price from value, and a guide published by Dave Van Knapp does a great job explaining how that works and also how to reasonably estimate a stock’s fair value.

I’m always on the lookout for an undervalued, high-quality dividend growth stock to add to my personal portfolio and I may just have found one.

Want to know more?

Read on.

Baxter International Inc. (BAX) is a diversified healthcare company that operates on a global scale. They manufacture and market medical products that are designed to save and sustain the lives of people with hemophilia, immune disorders, infectious diseases, kidney disease, trauma, and other chronic and acute medical conditions.

Healthcare is definitely an exciting sector of the economy to be invested in.

It’s expected to grow faster than the general economy as a combination of more expensive therapies and drugs come online and the large generation of baby boomers set into retirement and old age. Furthermore, unlike some products and/or services, one simply cannot skip paying for treatment, in most cases, especially if it’s life-threatening.

That means companies that have a wide portfolio of products and services that cater to people who need those products and services are well-positioned to benefit from these long-term tailwinds.

The good news is that Baxter has been sharing the wealth with shareholders: The company has increased its dividend for the past eight consecutive years.

And those increases have been generous, as the five-year dividend growth rate is 14.2%.

Yielding 3.08% right now, that’s not only attractive in comparison to the broader market, but also well above what this stock’s yield has averaged over the last five years.

And the payout ratio, at 58.4%, is moderate enough to ensure that the dividend is sustainable and will very likely continue to grow.

baxWhile BAX’s dividend growth streak isn’t as lengthy as some companies, there’s really a lot to like here.

You’ve got a healthy yield that’s well-supported by earnings and the dividend is growing at a generous clip.

We’ll next take a look at growth across the top and bottom lines, which will help us with valuing the business.

Revenue was $9.849 billion in fiscal year 2005. And it grew to $16.671 billion in FY 2014. That’s a compound annual growth rate of 6.02%, which is really solid.

Earnings per share increased from $1.52 to $3.56 over this period, which is a CAGR of 9.92%. Great growth here with both revenue and EPS.

S&P Capital IQ is anticipating that EPS will grow at a 6% compound annual rate for the next three years. I think there’s a good chance Baxter will actually exceed that, with the forecast for $4.70 for FY 2015.

I also always like to look at a company’s balance sheet to help determine the quality of the business. BAX last updated its balance sheet for FY 2013, and the long-term debt/equity ratio was 0.96, with an interest coverage ratio of 17.45. These numbers indicate that BAX is relatively healthy and fiscally responsible with debt usage.

The profitability of the company is also fairly impressive. They’ve posted net margin that’s averaged 14.89% over the last five years, which compares very well to other similar healthcare companies. Return on equity finished FY 2013 at 26.13%, which is, again, impressive.

Baxter offers a lot to like. You’ve got a very competitive dividend that’s growing at a rapid clip, the company’s product portfolio is diverse and, in many cases, necessary to sustain and save lives, and the underlying fundamentals are strong. I’m a shareholder in this company and you can probably see why.

Meanwhile, the company is also planning on spinning off its biopharmaceutical business in 2015, creating a new company called Baxalta. This could unlock further shareholder value, allowing both companies to focus on their strengths.

But is Baxter undervalued here?

Shares are trading hands for a P/E ratio of 18.98 here, though EPS is expected to grow rather substantially over the next year. Nonetheless, the current P/E ratio is more or less in line with both the broader market and just a little higher than the stock’s own five-year average.

What is this stock worth?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term growth rate. That rate appears fair considering the company’s historical growth, moderate payout ratio, and expected growth moving forward. The DDM analysis gives me a fair value of $74.19.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

The DDM analysis points to this stock being undervalued right now, but let’s take a look at some prevailing professional opinions on this stock’s fair value to get a broader picture.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates BAX as a 4-star stock, with a fair value estimate of $84.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates BAX as a 4-star “buy”, with a fair value calculation of $72.70.
So there’s a range there, but the stock appears undervalued no matter how you slice it. If we average out these three numbers to come to a firm consensus, we get $76.96 as the fair value. That would indicate this stock is potentially 14% undervalued right now.

sc baxBottom line: Baxter International Inc. (BAX) is a high-quality healthcare firm that provides a variety of healthcare solutions that are oftentimes necessary, and with an aging demographic there are numerous tailwinds that work in this company’s favor. The dividend is attractive and growing, and the company’s expected to grow at a healthy rate moving forward. Meanwhile, a planned spin-off could unlock even more value. Shares appear potentially 14% undervalued right now, which is a rarity in this market. This stock should be on your radar, if it isn’t already.

– Jason Fieber, Dividend Mantra

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